Know When to Walk Away

Front month equity options make me nervous. For investors with anything but nerves of steel — or a willingness to gamble away their premium — the closer expiry looms for in-the-money options, the more pressing the decision becomes as to when to close the position. Case in point: those QQQ calls which have now risen by nearly twenty times since April.

Back in June, I mentioned possible follow-up actions for long positions in the SPDR S&P 500 (SPY) calls at 171 in the March 2014 series and PowerShares QQQ (QQQ) calls at 80 in the January 2014 series. In April, they had traded for $2.62 and $.38, respectively, and they’d risen strongly enough by June to consider calendar spreads as a means of hedging gains. (See “Calendar Spreads as a Follow-Up Strategy for Longer Term Call Buys”.) By September, they were trading around $5.24 and $1.85, respectively, and I touched on the tension between hedging and simply taking large profits. (See “Keeping it Simple: Taking Profits Versus Hedging Long Calls”.)

Fast forward three more months, and today the options go for around $13.01 and $7.35, respectively, representing gains relative to September of nearly 150% and 300%, respectively. (Relative to April, the gains are closer to 400% and 1800%.)

Many investors using these or similar options will by now have closed at least part of their positions, taking handsome profits along the way. But there comes a time when what might appear at first glance to be “easy money” embodies so much risk that’s it’s no longer worth maintaining the exposure to more gains. In my view, for the QQQ options, which have just 25 days to expiry, that time is right about now. As Kenny Rogers told us in The Gambler, you need to know when to walk away.

Sure, QQQ could continue to scale new heights during the next few weeks, and the options could double in value with another 8% climb in the underlying. Or, they could be cut in half with a much smaller than 8% fall in QQQ. Regardless of one’s view of the ‘trend’ for QQQ, of the impact of Fed tapering, or of other factors, the point is that with so little time remaining, the returns for options held to expiry may be decided more by ordinary day to day volatility than by anything else. For those still maintaining profitable long positions in these options, the pressing question is whether the potential gains to the upside are worth the risk of a sharp break lower. And does holding the position make you a brave investor, or just a gambler?

All material on this site is carefully reviewed, but its accuracy cannot be guaranteed; please do your own checking and verifying. This specific article was last reviewed or updated by Dr Greg Mulhauser on December 23, 2013.

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